1. Campbell R. Harvey Duke University and NBER
Innovation and Cryptoventures
Stablecoins
Campbell R. Harvey
Duke University and NBER

2. Campbell R. Harvey 2019

3. Cryptocurrencies are too volatile
Bitcoin as a transaction method will not be viable until the volatility is decreased. Currently, it fails as a store of value.
Campbell R. Harvey 2019

4. Cryptocurrencies are too volatile
Holding for one week: 95% confidence interval is
Bitcoin: +/- 25%[from 2011]; S&P500 is -4.3% to +4.3%
Worst S&P daily return since 1957 is Oct. 19, 1987 at %
Over last 6 years, bitcoin has had 8 days with less than % return
Second worst daily return since 1957 is Oct 15, 2008 at -9.03%
In 2018 alone, more than 8 days with <-10% return
Campbell R. Harvey 2019

5. Stablecoin basics Four different types Fiat collateralized
Real asset collateralized
Crypto collateralized
Non-collateralized
Campbell R. Harvey 2019

6. Stablecoin basics Fiat-collateralized coins
Tether is the largest (USDT) also very controversial
TrueUSD (TUSD) exchange directly into escrow so TUSD never touches your USD
LBXPeg tied to sterling;
BitCNY
Candy backed by Mongolian tugrik
Sometimes called IOU coins – if there was ever a problem with the collateral, the token holders are owed the fiat.
Campbell R. Harvey 2019

7. Stablecoin basics Fiat-collateralized coins
USDC (Circle) accepted on many exchanges like Poloniex (which Circle owns)
Paxos Standard (PAX) and Gemini Dollar (GUSD) approved by New York State Department of Financial Services
Campbell R. Harvey 2019

8. Stablecoin basics
Campbell R. Harvey 2019

9. Stablecoin basics Real asset-collateralized coins
Digix Gold (DGX) ERC-20 and 1 DGX=1 gram of gold. Gold in vault in Singapore and audited every three months. Can redeem in physical gold.
Tiberius Coin (TCX) combo of 7 precious metals used in tech hardware
Swiss Real Coin (SRC) backed by portfolio of Swiss real estate. Interesting, the holders vote on the investment choices!
D1 Coin. Collateralized with diamonds.

10. Stablecoin basics Crypto-collateralized coins:
Suppose you own a house and want a home equity loan. The bank gives the loan but you pledge your house as collateral. The collateral is worth more than the loan (over-collateralized).
If the house drops in value, the loan may be called. If you can’t payback, the house is auctioned off.
This is an example of a Collateralized Debt Position or CDP
New space: Augmint (pegged to Euro – called A-Euro), Haaven (Haaven is the collateral and nUSD is the stablecoin), Sweetbridge
Let’s explore MakerDAO’s DAI
Campbell R. Harvey 2019

11. Stablecoin basics
Campbell R. Harvey 2019

12. Stablecoin basics Crypto-collateralized coins: MakerDAO
DAI is a cryptocurrency that is has a mechanism that allows it to be pegged to the USD. So $1=1 DAI (approximately).
In existence for about one year.
Campbell R. Harvey 2019

13. Stablecoin basics Crypto-collateralized coins: MakerDAO
Suppose 1 ETH= $100. In addition, suppose the initial collateral ratio is 1.5 (you must post $1.50 in collateral for every DAI borrowed)
You send 1 ETH to a smart contract which allows you to borrow 66 DAI (some rounding). There is also a “stability fee” which is similar to interest.
As long as ETH>$100, then the system is secure. However, what happens if ETH drops in value?
Campbell R. Harvey 2019

14. Stablecoin Campbell R. Harvey 2019

15. Stablecoin basics Crypto-collateralized coins: MakerDAO
Suppose ETH drops to $75. In addition, the “maintenance” margin collateralization ratio is The drop in ETH triggers the equivalent of a margin call.
You need to repay by sending 66 DAI to the contract. After doing that, you would be refunded the residual (about 0.25 ETH)
If you do not repay, you will be liquidated.
Campbell R. Harvey 2019

16. Stablecoin basics Crypto-collateralized coins: MakerDAO
There is a group called “keepers” that are constantly checking the blockchain for contracts that have fallen below the maintenance margin. They can trigger a liquidation.
Keepers is a general term for those that maintain a blockchain – they are not specific to MakerDAO
Campbell R. Harvey 2019

17. Stablecoin basics Crypto-collateralized coins: MakerDAO
In our contract, there is 1 ETH. These ETH are auctioned off for DAI. To be clear, the trade is selling ETH and buying DAI (which should have a positive price impact on DAI)
The auction is looking to sell enough ETH to obtain 66 DAI
Price of ETH is $75. Usually, this would cost 0.88 ETH (66/75).
However, in the auction you might need to pay more than 0.88 ETH (which means the price of DAI increases relative to ETH)
Campbell R. Harvey 2019

18. Stablecoin basics Crypto-collateralized coins: MakerDAO
After the 66 DAI are paid off, the residual is paid back to the borrower. Suppose the DAI are bought in auction for 0.90 ETH. This means that 0.1 ETH is returned to you
The 66 DAI are destroyed (reducing the supply of DAI)
The stability mechanism works the other way too – if DAI increases above the peg, then the collateralization ratio is changed. Who changes the collateralization ratio?
Campbell R. Harvey 2019

19. Stablecoin basics Campbell R. Harvey 2019

20. Stablecoin basics Crypto-collateralized coins: MakerDAO
There is much more to the system than my explanation
The maker token MKR holders determine the collateralization rates and they regulate the system (and get paid for it)
However, MKR are the buyers of last resort – if there was ever a situation where there was not enough collateral to cover the DAI, MKR is created and sold to cover the residual
MKR holders are, hence, strongly incented to responsibly regulate.
Campbell R. Harvey 2019

21. Stablecoin basics Crypto-collateralized coins: MakerDAO
There is also a fail safe called Global Settlement
If the system under attack, a Global Settlement is triggered where you can exchange the DAI directly for ETH through a smart contract and collateral will be released to the owners
Campbell R. Harvey 2019

22. Stablecoin basics Crypto-collateralized coins: MakerDAO
DAI also allows for leveraged ETH positions
Suppose you have 1 ETH = $100 and you enter into a CDP and get 66 DAI.
You use DAI to buy more ETH (0.66 ETH). [Assume do this only once.]
Now you profit (or lose) with leverage.
Suppose price rises, e.g., ETH=$200
You would usually have profited by $100 or 100% return
You have 1.66 ETH which is worth $332. You buy 66 DAI for $66 and repay the CDP leaving you with $266 (a profit of 166%)
Campbell R. Harvey 2019

23. Stablecoin basics Crypto-collateralized coins: MakerDAO
DAI also allows for leveraged ETH positions
Note as the collateralization ratio decreases, the amount of leverage increases.
Theoretically, as leverage approaches 1:1, you can get infinite leverage!
However, importantly, the lower the collateralization ratio, the more DAI are created
Campbell R. Harvey 2019

24. Stablecoin basics Crypto-collateralized coins: MakerDAO
Finally, currently the system allows for only one type of collateral: ETH
In the future, they will generalize this to any ERC-20 or ERC-721 token
This opens a range of interesting ideas. For example, you might have an ERC-20 that represents an investment in a diversified portfolio of stocks and bonds. Essentially, almost any collateral (as long as it is tokenized) can be pledged.
Campbell R. Harvey 2019

25. Stablecoin basics Crypto-collateralized coins: MakerDAO
Other information
Andy Milenius at Devcon4, December 10,
Campbell R. Harvey 2019

26. Stablecoin basics
Non-collateralized coins: Basis, Carbon, Kowala (mUSD, kUSD), Fragment/Ampleforth
Basecoin – dynamic monetary policy that uses a three token system (coin, bonds and shares). They had to shut down December 18, 2018 because regulatory issues (bond and stocks were securities). Nevertheless, let’s explore their idea.
1. Coin:
Supply shifts to keep demand at, e.g., $1 to maintain peg
If price increases, more coin is created; if price decreases, coin is purchased to decrease supply
“A stable cryptocurrency with an algorithmic central bank”
Campbell R. Harvey 2019

27. Stablecoin basics Non-collateralized coins 2. Bonds:
Generated whenever supply needs to contract
Bonds are redeemable for 1 coin in future if:
Supply is expanding
Bond hasn’t expired (5-year window)
Your bond is next in line
Sold for less than $1 to achieve yield (here is where the regulatory issue kicks in because qualifies as a security)
Campbell R. Harvey 2019

28. Stablecoin basics Non-collateralized coins 3. Shares: Supply is fixed
Excess basecoin supply paid to shareholders (after outstanding bonds)
Proportional to ownership (again seems like a security)
Thus bonds incentivize contraction of supply and bond and shareholders are recipients of expanding supply and the peg can be maintained “via game-theory and economics”
Campbell R. Harvey 2019

29. Stablecoin basics Kowala protocol
Vision is a series of k-coins, kUSD, kEUR, …
White paper
1 second confirmations in Go Ethereum
Three stability mechanisms
Campbell R. Harvey 2019

30. Stablecoin basics Kowala protocol
Stability mechanism #1: Minting algorithm
If kUSD rises above $1, then more supply is added (so the block reward is variable)
If kUSD falls below $1, mining reward goes to zero – however, that might not be sufficient to drive the price back
Campbell R. Harvey 2019

31. Stablecoin basics Kowala protocol
Stability mechanism #2: Stability fee
Like Ethereum, every transaction sender is charged a fee (in part to compensate miners for maintaining the network). This fee also includes a “stability fee” which is 0-2% of the transaction amount. The fee serves to reduce coin supply when price is below $1. Note the max is 2% and usually the stability fee would be zero (in normal conditions)
Campbell R. Harvey 2019

32. Stablecoin basics Kowala protocol
Stability mechanism #3: Trading activity
First two mechanisms are first order effects and are designed to keep kUSD close to $1. There is a second order effect. Given that market participants understand the peg, there exists a natural Schelling (focal) point (parity). That is, arbitrageurs will enter the market if the price falls below $1 and start to buy.
Campbell R. Harvey 2019

33. Stablecoin basics Kowala protocol Other
Two token system: kUSD and mUSD, where mUSD is a mining token. There is a fixed number of mUSD for every kUSD.
Consensus mechanism (Konsensus) derived from Tendermint and uses Practical Byzantine Fault Tolerance (PMFT). They believe superior to Proof of Work.
There are miners. For every block, a leader (called proposer) is deterministically elected from miners. All other miners are validators. Proposer assembles the next block and the validators decide whether to accept or reject. Proposer gathers pending transactions of offers to the validators for formal verification. If two thirds or more vote to accept the block, proposer commits it to the blockchain. If block is rejected, a new proposer is elected.
The likelihood of being elected as a proposer depends on the number of mUSD you have.
Campbell R. Harvey 2019

34. Stablecoin basics Kowala protocol Other
Dishonest or free-loading miners punished by becoming ineligible to propose blocks (need to be active to participate); Also, in order to be eligible, miner needs to stake mUSD tokens (currently 30,000); Maximum number of miners;
Energy efficient
7,000+ tps with processing time of 1 second
Campbell R. Harvey 2019